Do ETF Managers Eat Their Own Cooking?

Exchange-traded fund families urge you to join the ETF revolution, but many of the people managing their own funds are sitting the uprising out.

I recently looked at the regulatory filings of some of the largest and fastest-growing ETF families to see how ETF managers are compensated and if they are investing any of their own money in the funds their employers are hawking so aggressively. This information can help investors figure out how much ETF managers really believe in the funds they run.

The result was disappointing.

For most of the funds I checked, few of the managers had anything more than a token amount invested in the ETFs they ran, according to their funds' most recent disclosures with the Securities and Exchange Commission. The managers of Barclays Global Investors' iShares and State Street Global Advisors' streetTracks and SPDR ETFs had no money in their funds as of their most recent disclosure, while managers at Vanguard and PowerShares had at least some money invested alongside their shareholders. Of those firms, only Vanguard linked manager bonuses to the performance of funds they ran.

Should this matter? After all, most ETFs are market (or market segment) tracking index funds that are extremely tax efficient on their own, so it's not like an ETF skipper needs incentive to beat the market or manage taxable distributions.

I think it does matter, though, for the same reasons it matters for conventional open-end funds. Simply put, the interests of managers who are compensated based on how well they run their funds, and who have significant sums of their own money invested in their portfolios, are more aligned with their shareholders. Whether a fund is active or passive, exchange-traded or traditional, managers are more likely to ensure a fund delivers what it promises for a reasonable fee if their own wealth is on the line.

Manager compensation seems like a particularly important factor to consider as more and more new ETFs flood the market touting paradigm-shifting methodologies and strategies. Looking at where ETF managers invest their own money can help investors discern which funds are based on legitimate investment cases and which are hyped-up asset-gathering vehicles.

Granted, it isn't as dangerous for index funds to pile up assets because their low turnover and limited mandates allow them to run a lot of money without compromising strategy and performance. But ETF managers usually are intimately involved in their firms' product development efforts, and if their pay is tied to sales or if they have no intention of using the funds themselves, they may be more likely to acquiesce to dubious fund ideas, such as ETFs that track narrow benchmarks or illiquid securities.